Reading 7: The Behavioral Finance Perspective

Question 1

Bounded Rationality

Answer 1

Individuals act as rationally as possible, realising they do not have all the available information or cognitive ability to fully interpret the information. Individuals practice satisfice (not optimal utility).

Question 2

Heuristic Learning

Answer 2

Not through research but through their own efforts or from sources simple to access. Are updated over time, alternative to updating beliefs with Bayes Formula.

Question 3

Traditional Vs Behavioural Process

Answer 3

Traditional involves statistical measures of risk and return, where behavioural is lifestyle-based objectives. Move from dispersion-based measures (traditional) to the probability that a stated objective will be realised.

Question 4

Expected Utility Theory

Answer 4

Trying to maximise PV of utility. Assumes risk aversion.

Question 5

Mental Accounting Bias

Answer 5

Observation that investors group wealth (or expenditures) into certain groups, each group has its own objectives and therefore tend not to be analysed as the individual’s total wealth but as seperate layers.

Question 6

Traditional Finance

Answer 6

People are rational, risk averse, have perfect info, and are utility maximisers. Normative decision making. Four axioms: Completeness (known preferences); transitivity (consistently apply preferences); independence (rankings are additive and proportional); continuity (combinations are possible). New info updates probabilities through Bayes formula. Markets are efficient and reflect fundamental value, managers identify portfolios on efficient frontier.

Question 7

Behavioural Finance

Answer 7

Individuals may be risk-averse (concave, diminishing marginal utility of wealth), risk neutral (constant marginal utility of wealth), to risk seeking (convex, increasing marginal utility of wealth).

Question 8

Prospect Theory

Answer 8

Focusing on framing outcomes as either gains or losses and weighting uncertain outcomes (making choices). Assumes loss aversion not risk aversion (change in wealth not overall ending wealth). Reject gain when loss and gains have same probability, unless the gain is twice as much as the loss. Two phases of making choice: editing phase to frame proposals (codification, combination, segregation, cancellation, simplification (rounding), detection of dominance); and evaluating that determines utility with equation. Individual are risk averse with high probs of gains and low probs of loss, but risk seeking with high probs of losses and low probs of gains.

Question 9

Behavioural Finance Alternatives Models

Answer 9

Consumption & Savings: traditional assumes investors show self control, behaviour assumes they spend from current income.
Behavioural Asset Pricing: adds sentiment premium to CAPM for the discount rate, high premium shows high dispersion of analyst forecasts (not strength).

Question 10

Behavioural Finance Alternatives Models

Answer 10

Behavioural Portfolio Theory: traditional assumes diversified portfolio comes from combo of risk free lending and Markowitz optimal portfolio of risky assets (mean variance performance goals). Behavioural assumes construction with layers reflecting different risk and return expectations, allocating to layers based on individuals goals; maximises wealth with constraints to meet aspirational level with low risk. Can be sub optimal as layer correlations are not considered.

Question 11

Behavioural Finance Alternatives Models

Answer 11

Adaptive Markets Hypothesis: Success in markets is an evolutionary process. Survival is a goal over maximising utility. Investors satisfice rather than maximise utility. Heuristics eventually get reflected in market prices (no longer work).